Bythe Monitor's Editorial BoardMarch 4, 2015

With all her focus on economic data, Federal Reserve Chair Janet Yellen rarely speaks of a difficult soft topic for a government regulator: ethics in corporate culture. Yet in a speech Tuesday she suggested that employees of large financial firms have “pervasive shortcomings” in values.

She decried recent brazen behavior in some banks and a need for stronger governance. “It is unfortunate that I need to underscore this, but we expect the firms we oversee to follow the law and to operate in an ethical manner,” Ms. Yellen said.

Since the 2008-09 crisis, banks have certainly improved in levels of capital and liquidity as well as governance, Yellen said. But “compliance breakdowns” in recent years show “room for improvement.”

Despite tougher federal rules and supervision imposed on firms since the Great Recession, such as the 2010 Dodd-Frank Act, regulators say the new measures may simply not be adequate to avoid dangerous risk-taking in large firms and ensure stability of the banking system. One Fed governor, Daniel Tarullo, said recently that many bank employees have an attitude of “mere compliance,” or rotely following regulations in an “almost check-the-box fashion.”

To nudge the big banks, the Fed has begun to put them under “stress tests” that include subjective judgments on the “qualitative” aspects of each bank’s operation, such as risk management. “A strong ethical culture will lead to better behavior,” said Thomas Baxter Jr., general counsel of the Federal Reserve Bank of New York, in a January speech.

Many banks have tried to stay ahead of regulators. At J.P. Morgan, for example, employees are now often questioned on ethics. And the company tries to measure its “culture” by the number of “adverse regulatory events.” At Citigroup Inc., said chairman Michael O’Neill in a recent speech, “If someone sees something untoward, and doesn’t report it, he or she will be deemed as guilty as the party who committed the infraction.”

Mr. Tarullo says executives that once blamed “bad apples” for a firm’s problem have lately begun to realize that they themselves must make sure all employees hold up “the values of probity, customer service, and ethical conduct that most of them espouse on their websites and in their television commercials.”

Fed officials are warning Wall Street that it faces more rules and punishment if banks do not do more to improve worker attitudes, not just behavior. Yet firms find it difficult to always prevent workers from cutting corners, deceiving clients, or other types of malfeasance. Relying on fear of punishment is rarely sufficient to instill values such as honesty and trust in employees. And “culture” is an elusive word, one more easily perceived than described or tallied up like a spreadsheet.

Tarullo speaks of “good compliance” by banks, not mere compliance. Fed officials are on the right track if they expect good thinking in financial workers. The more regulators remind banks of it, as Yellen did in her speech, the more they might find it.